Hidden and Unexpected Risks

Written by Brooke Smith on Thursday, August 26th, 2010 at 11:54 am

“The risk measures used over last few years have been disappointing,” said Janet Rabovsky, senior investment consultant with Towers Watson, speaking at the 12th annual Risk Management Conference in Muskoka, Ont.

Plan sponsors in Canada thought alternatives—private equity, real estate infrastructure, commodities—would get them out of the bad situation. In fact, pension plans have been allocating more to alternatives. In 1999, pension plans allocated 6% to alternatives. In 2009, that number had increased to 22%. “[But] out of the last few years, we didn’t do very well,” said Rabovsky. “We had started to change the way we looked at the capital markets and had very little regulation to support that.”

There were three areas that caused the credit crisis: too much credit, belief that the markets knew best (the idea that the market was going to right itself) and excess of complexity, competition and compensation. In managing risk, then, the tactics used have to be far more complex than what we’ve been using, said Rabovsky.

Plan sponsors need to look at what type of asset classes they want to be in and look for asset classes that are less correlated. Leverage also needs to be reduced. And plan sponsors need to review quant/leverage and refine their manager profiles.

Macro Factors

Some of the bigger issues that may affect global returns include demographics and emerging wealth. However, investors have started to look at geopolitics (terrorism, competition for resources, free trade) and public policy (G8 deficits, managed foreign exchange, inflation/deflation). Out of 15 extreme risks to consider, the first six—depression, hyperinflation, excessive leverage, currency crisis, banking crisis, sovereign default—are related to the concept of leverage.

The challenge for plan sponsors is do they manage for expected outcomes or do they manage for their fears or worst expected outcomes? You need to think about what it is you need to discuss as a committee when things go wrong. How are you going to act? said Rabovsky. “Risk isn’t a four letter word. Unintended risk is.”